How much due diligence is enough when dealing with Chinese companies? Here’s a better way to ask the question: If Chinese companies are beyond the reach of U.S. law, is any amount of due diligence enough?
Beyond the reach of U.S. law? That’s right (see below). And if Chinese companies are beyond the reach of U.S. law, should anyone expect them to set up and run effective compliance programs — no matter how they answer due diligence questionnaires?
Some background: In April, honchos at the SEC and the head of the PCAOB issued a stunning public statement. It warned investors about special risks from “emerging markets” that the feds can’t protect them from. “Emerging markets” turned out to be a transparent euphemism for “Chinese companies.”
The public statement described the PCAOB’s inability to inspect audit work papers in China, the limited ability of U.S. authorities including the SEC and DOJ to bring and enforce legal actions against Chinese companies and their bad actors and gatekeepers, and the absence in China of predictable shareholder rights and protections, among other things.
To help potential investors a bit, the SEC instructed registrants from “emerging markets” to disclose those special risks, and that has happened.
A typical example is the F-1 registration statement filed last month by Yatsen Holding Limited, a beauty-products company based in Guangzhou but incorporated in the Cayman Islands.
“We are an exempted company incorporated under the laws of the Cayman Islands, however, we conduct substantially all of our operations in China and substantially all of our assets are located in China,” one section in “risk factors” said.
All of Yatsen’s senior executive officers are PRC nationals living in China most of the time, the disclosure said. “As a result, it may be difficult for you to effect service of process upon us or our management named in the prospectus inside mainland China.”
The disclosure continued:
It may also be difficult for you to enforce judgments obtained in U.S. courts based on the civil liability provisions of the U.S. federal securities laws against us and our officers and directors as most of them currently resides outside the United States. In addition, there is uncertainty as to whether the courts of the Cayman Islands or the PRC would recognize or enforce judgments of U.S. courts against us or such persons predicated upon the civil liability provisions of the securities laws of the United States or any state.
And finally, this:
China does not have any treaties or other forms of written arrangement with the United States that provide for the reciprocal recognition and enforcement of foreign judgments. In addition, according to the PRC Civil Procedures Law, the PRC courts will not enforce a foreign judgment against us or our directors and officers if they decide that the judgment violates the basic principles of PRC laws or national sovereignty, security or public interest. As a result, it is uncertain whether and on what basis a PRC court would enforce a judgment rendered by a court in the United States.
Yatsen said its legal advice came from Maples and Calder for Cayman Islands law, and Zhong Lun Law Firm for PRC law.
Here’s the question: Is it reasonable to expect companies inside China to comply with foreign laws that can’t be enforced against them? The FCPA, OFAC trade sanctions, anti-money laundering rules, and so on?
It’s true that aside from U.S. legal concerns, some Chinese companies have a lot of incentive to be clean. After all, they want to win and keep international business, right?
But there’s another equally practical way to look at it, and it’s also about money.
Let’s assume companies outside China with $1 billion in annual revenue typically spend $15 million a year (my made-up number) for FCPA, OFAC, and AML compliance. Again, is it reasonable to expect equivalent companies in China to spend anywhere near $15 million a year to comply with laws that can’t be enforced against them? A realistic cost-benefit analysis might instead suggest a very different budget allocation for some or all of the $15 million.
The United States and other countries aren’t going to prohibit doing business with every Chinese company because of jurisdictional issues.
So, we’re left with this: Can any amount of due diligence provide adequate assurance about supply-chain compliance in China? Or, has the SEC alerted everyone to another deep pool of uncertainty and risk that compliance officers must somehow find a way to manage?